Originators Counting on Docs to Keep Subprime 'Responsible'

With subprime lending on the rebound, a lot of mortgage originators are tempted to dip in the pool but fearful that the sorts of problems that emerged in the 2005 to 2007 era will reappear.

The question many are pondering: Is there a way to do subprime that's safe? It’s what Jack Kahan, a residential mortgage specialist at Standard & Poor's, calls “responsible subprime."

Subprime, of course, is a term that originally popped up to describe loans to borrowers with less-than-prime credit scores. As the last housing bubble inflated, however, the definition was expanded to include loans backed by high loan-to-value ratios, minimal documentation and other risky features.

Lenders won't bend underwriting criteria so far this time as to provide borrowers with low credit scores with layered risk, Kahan says. Instead, he told National Mortgage News he believes such loans will be prevented by documentation requirements that hold lenders responsible for ensuring borrowers' ability to repay.

"It would be hard to see no- to low-doc lending standing up to QM standards," agreed CoreLogic chief economist Mark Fleming.

There is a complete absence of new no-doc loans and only a smattering of low-doc loans, Fleming says. That, he adds, contrasts sharply with the 2005 to 2007 period.

In addition to the strict new documentation standards, third parties and automation will help lenders and investors verify the integrity of that information and prove important in preventing subprime abuses, says Phil Huff, CEO of Platinum Data Solutions, an Aliso Viejo, Calif.-based firm that provides collateral valuation technology.

"There needs to be an uber-focus on quality of information," he says. "Is the person who they say they are? Is the quality worth what is being lent on it, and is the person capable of repaying the loan?"

With that in mind, the new "subprime" might prove very different than its predecessor. This time around, below-prime loans are likely to be defined as those that do not qualify as qualified mortgages but are eligible for a safe harbor from ability-to-repay liability.

"Some people are referring to that as the new subprime, which I think is at least semi-appropriate," Huff says.

Lenders to date have opened up the credit box slightly, but it is far from the point where it would cause alarm, says Stanley Middleman, CEO of Freedom Mortgage in Mount Laurel, N.J.

"I think you've seen the funnel widen, but not extraordinarily so. I would say the funnel is still narrower than it was as recently as 2009," he says. Middleman describes his company as a QM lender that has only contemplated a broader reach.

Based on historical performance, borrowers that are "fairly deep in the reputational pool" in terms of credit scores should probably be limited to no larger than a $300,000 to $350,000 loans and 65% loan-to-value ratios, Middleman says.

When it comes to loosening underwriting standards, lenders have turned more toward higher LTVs than lower credit scores. LTVs have been rising for about the last 18 months, but only for borrowers with relatively high credit scores, says Jeff Bradford, CEO of appraisal automation provider Bradford Technologies in San Jose, Calif.

Average LTVs are currently in the 87% to 89% range and home equity lending has been growing, says Fleming. However, the volume of home equity products remains much lower than it was during the 2005 to 2007 era, he says.

Even with home prices generally rising, lenders and investors should be careful about rising LTVs, given the role declining home prices hurt loan performance during the bust, Middleman says.

"It wasn't long ago that we got burnt pretty badly. A lot of it was not being prepared for a downturn in property values" in which underwater borrowers abandon their homes and payments, he says.

Ultimately what will define the bounds of "reasonable subprime" will be originators’ risk-based pricing models, regulation and the dictates of the government-sponsored entities that control the secondary market. This should help keep unhealthy loosening of underwriting standards in check.

Government guarantees largely protect much of the securitized market from this credit risk, with the exception of agency risk-sharing initiatives that involve selling some of Fannie Mae and Freddie Mac credit risk to private investors, Fleming notes.

"The industry is going to behave in a fashion that limits its liability," says Middleman. "If the return supports the risk, lenders will make the loan, but we've been regulated into a fairly tight box that is limited by returns that have been somewhat limited as well."